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Claiming Bonus Depreciation on Self-Constructed Long Production Period Assets

The Small Business Jobs Act of 2010, P.L.
111-240, extended 50% bonus depreciation for
assets placed in service before January 1, 2011.
The Tax Relief, Unemployment Insurance
Reauthorization, and Job Creation Act of 2010,
P.L. 111-312 (TRA 2010), created 100% bonus
depreciation for assets placed in service after
September 8, 2010, and before January 1, 2012,
and extended 50% bonus depreciation for assets
placed in service after December 31, 2011, and
before January 1, 2013.

Both acts contain
binding contract exceptions. The first exception
is that bonus depreciation of either 50% or 100%
cannot be claimed for assets acquired after
December 31, 2007, and placed in service before
(or after) the applicable dates if the asset was
acquired under a written binding contract
entered into prior to January 1, 2008. Under TRA
2010, a taxpayer cannot claim 100% bonus
depreciation for assets acquired after September
8, 2010, and placed in service before January 1,
2012, if the taxpayer acquired the asset under a
written binding contract entered into before
September 9, 2010. In the case of certain assets
(longer production period property,
transportation property, and certain aircraft),
50% bonus depreciation is available if the asset
is acquired under a binding contract entered
into after December 31, 2007, and before January
1, 2013, and the asset is placed in service
prior to January 1, 2014. A similar binding
contract rule applies to these assets with
respect to 100% bonus depreciation with
appropriate date modifications.

Although
the binding contract rules seem simple enough to
apply with respect to acquired property, the
waters become a bit muddied when the taxpayer’s
qualified property is self-constructed.
Self-constructed property can be broken down
into two general categories. The first category
is enumerated in Sec. 168(k)(2)(B) (“Certain
property having longer production periods”). The
other category would include everything else (or
property that does not have a longer production
period) that is otherwise qualified property.
This item addresses self-constructed property
having a longer production period, since the
general rules are applicable to the latter
category. In March 2011 the IRS issued Rev.
Proc. 2011-26, in part to clarify how the
binding contract rules apply to self-constructed
longer production period assets and to provide
an election to “componentize” the costs
associated with such projects to account for the
different phases of bonus depreciation available
to the taxpayer for such projects.

Self-Constructed Assets

First, a little background is needed on
self-constructed longer production period
assets. In order to qualify for bonus
depreciation, these assets must meet the general
qualification rules for Sec. 168(k). Under Sec.
168(k)(2), qualified property means Sec. 168
property that has a recovery period of 20 years
or less, computer software that is depreciable
under Sec. 167(a), water utility property, or
qualified leasehold improvement property, the
original use of which commences with the
taxpayer after December 31, 2007, subject to the
binding contract rules described above and
placed in service prior to January 1, 2014. In
addition, the property must meet the following
additional requirements:

The
property has a recovery period of at least 10
years or is transportation property;

It is subject to the uniform
capitalization rules under Sec. 263A; and

It must have an estimated production
period exceeding one year and an estimated
cost exceeding $1 million as set forth in Sec.
263A(f)(1)(B)(iii).

Applying the Rules

Assuming
the self-constructed longer production period
assets meet these requirements, the taxpayer
must then determine how the binding contract
rules and placed-in-service rules apply to its
particular project. First, under Sec.
168(k)(2)(E)(i), self-constructed property meets
the requirement of being acquired after December
31, 2007, and before January 1, 2013, if the
taxpayer begins production of the property
during this period. Regs. Sec.
1.168(k)-1(b)(4)(iii)(C)(1) further provides
that if costs are incurred or components are
acquired after December 31, 2007, and relate to
a “larger self-constructed project” that began
before December 31, 2007, such costs incurred or
components acquired will not qualify for the 50%
bonus depreciation. Sec. 168(k)(5) (the 100%
bonus depreciation provision) states that for
purposes of the 100% bonus depreciation, “rules
similar” to the acquisition and
placed-in-service general rules will apply to
qualifying assets for purposes of claiming 100%
bonus depreciation, with appropriate adjustments
for the applicable dates (i.e., after September
8, 2010, and before January 1, 2012). But here
is where it gets interesting.

Rev. Proc.
2011-26, Section 2.04, indicates that the IRS
will allow a limited exception for “certain
components” as set forth in Section 3.02(2)(b)
of the revenue procedure. Under the general rule
above, if the taxpayer incurs the costs after
the effective date (December 31, 2007) for a
larger self-constructed project that the
taxpayer began prior to the effective date, the
additional costs would not qualify for bonus
depreciation. It may seem that this rule would
also be applicable to self-constructed assets
for 100% bonus depreciation rules, so that for a
larger self-constructed project started before
September 8, 2010, costs incurred after that
date would not qualify for 100% bonus
depreciation. However, under its authority to
interpret legislation, the IRS has granted
itself some latitude in the application of these
rules due to the use of the word “similar” (as
opposed to “same”) within the statutory
language. Section 3.02(2)(b) provides that
solely for purposes of Sec. 168(k)(5) (100%
bonus depreciation), the IRS will allow a
limited exception for larger self-constructed
property where the production began after
December 31, 2007, and before September 9, 2010.
Under this exception, for otherwise qualified
property, costs incurred after September 8,
2010, and before January 1, 2012 (before January
1, 2013, in the case of qualified property
described in Sec. 168(k)(2)(B) or (C)), will
qualify for 100% bonus depreciation. The
taxpayer must elect on a component-by-component
basis to have this provision apply.

To
further illustrate how these rules apply, Rev.
Proc. 2011-26 provides several examples.

Example 1—Acquired property and
self-constructed property not eligible for
the 100% additional first-year depreciation
deduction: In June 2008, X begins
constructing an electric generation power plant
for its own use. In February 2009, prior to the
plant’s completion, X and Y (an unrelated
party) enter into a written binding contract
under which X transfers the rights to own
and use this power plant to Y for $2
million. On March 1, 2009, Y begins
construction to complete the plant. Between
March 2009 and August 2010, Y incurs
another $10 million to complete construction.
This $10 million includes amounts for components
that Y acquired under written binding
contracts entered into after March 1, 2009, and
for self-constructed components, the
construction, manufacturing, or production of
which began after March 1, 2009. Y
completes construction of the power plant in
August 2010. On October 1, 2010, Y places
the plant in service. The plant is included in
asset class 49.13 of Rev. Proc. 87-56 and has a
recovery period of 20 years under Sec. 168(c).

In this
example, Y must first determine if the
project qualifies for bonus depreciation under
the general rules. Because Y acquired
(and began) the project after December 31, 2007,
it was not part of a larger self-constructed
project that Y began before December 31,
2007, and the property otherwise met the
definition of qualified property under Sec.
168(k)(2), the property qualifies under the
general rule for bonus depreciation.

Next, Y must determine if the project
or any of its components qualify for the special
100% bonus depreciation. Although the original
use (placed-in-service date) of the project
began with Y after September 8, 2010, and
before January 1, 2013, the project as a whole
does not meet the acquisition rule under Sec.
168(k)(5) because the property was acquired
under a binding contract entered into prior to
September 9, 2010, and the self-constructed
portion of the project began before September 9,
2010.

Y must then determine if any of the
project’s component costs qualify for 100% bonus
depreciation under the special exception set
forth in Rev. Proc. 2011-26, Section 3.02(2)(b).
Under this exception, if a taxpayer began a
larger self-constructed project before September
9, 2010, but incurred costs for project
components after September 8, 2010, the
component costs incurred after September 9,
2010, will qualify for 100% bonus depreciation,
assuming the placed-in-service rule is met
(prior to January 1, 2013). In this example,
Y did
not incur any costs associated with the project
after September 8, 2010, so under the special
exception none of the project costs qualify for
100% bonus depreciation. In summary, all the
costs that Y incurred for the project
qualify for 50% bonus depreciation.

Example 2—Acquired property and
self-constructed property partially eligible
for the 100% additional first-year
depreciation deduction: In August
2009, X begins constructing an electric
generation power plant for its own use. On
September 1, 2010, prior to the plant’s
completion, X and Y (an unrelated
party) enter into a written binding contract,
and X transfers the rights to own and use
this plant to Y for $5 million. On
September 15, 2010, Y begins construction
to complete the plant. Between September 15,
2010, and November 2011, Y incurs another
$10 million to complete construction. This $10
million includes amounts for components that
Y acquired after September 15, 2010, and
for self-constructed components, the
construction, manufacturing, or production of
which began after September 15, 2010. Y acquires all
components to complete construction of the plant
under written binding contracts entered into
after September 1, 2010. Y completes
construction of the plant in November 2011. On
December 15, 2011, Y places the
power plant in service. The plant is included in
asset class 49.13 of Rev. Proc. 87-56 and has a
recovery period of 20 years under Sec. 168(c).

In this
example, Y must first determine if the
project qualifies for bonus depreciation under
the general rules. Because Y acquired (and
began) the project after December 31, 2007, it
was not part of a larger self-constructed
project that Y began before December 31,
2007, and the property otherwise meets the
definition of qualified property under Sec.
168(k)(2), the property qualifies under the
general rule for bonus depreciation.

Next, Y must determine if the project
or any of the project’s components qualify for
the special 100% bonus depreciation. Although
the original use (placed-in-service date) of the
project began with Y after September 8,
2010, and before January 1, 2013, the project as
a whole does not meet the acquisition rule under
Sec. 168(k)(5) because the property was acquired
under a binding contract entered into prior to
September 9, 2010; the self-constructed portion
of the project, although it began after
September 8, 2010, does not qualify under the
general rule because it was part of a larger
project that began on September 1, 2010 (the
date the partially completed plant was
acquired).

Y must then determine if any of the
project’s component costs qualify for 100% bonus
depreciation under the special exception set
forth in Rev. Proc. 2011-26, Section 3.02(2)(b).
In this example, Y incurred all
additional costs associated with the project
after September 8, 2010, so under the special
exception the costs associated with the
self-constructed portion and related component
costs would qualify for the 100% bonus
depreciation because these costs were incurred
after September 8, 2010. In summary, Y
can claim 50% bonus depreciation on $5 million
of costs, and the remaining $10 million of costs
will qualify for 100% bonus depreciation if
Y makes the component election. If the
election is not made, the full $15 million of
costs will qualify only for the 50% bonus
depreciation.

The taxpayer can make the
component election for one or more components
that are described in Section 3.02(2)(b) of Rev.
Proc. 2011-26. The taxpayer must make the
election by the date (including extensions) of
the federal tax return for the taxpayer’s tax
year in which it places the larger
self-constructed project in service. The
election is made by attaching a statement to the
return indicating that the taxpayer is making
the election under Rev. Proc. 2011-26, Section
3.02(2)(b), and whether the taxpayer is making
the election for some or all of the components
of the self-constructed project.

Conclusion

Although the
binding contract rules seem clear on the
surface, when a taxpayer’s asset for which it
wants to claim bonus depreciation is a
self-constructed longer production period asset,
the rules can become quite complicated. The IRS
has provided additional guidance for this
category of asset in Rev. Proc. 2011-26, and
taxpayers and their advisers should review the
revenue procedures to determine how the general
rules and created exceptions may apply to their
particular situations.

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